The Exponentiality of Municipal Costs (and Some Advice for Endowments and Foundations)

The word in social media is "exponentiality" of growth. Webster's, American
Heritage, and Microsoft Word do not acknowledge it, I don't know how
to spell it, but this path-breaking discussion of rising municipal costs
deserves a word from the future.

The pension costs of states and municipalities in years hence are often stated
in a calculation of future liabilities. For instance, the future obligations
of state and municipal pension funds are calculated (in frequently cited studies)
at between $1.5 trillion to $3.5 trillion.

Among the reasons for this range are the assumptions used by the actuary who
produces the pension valuation, an annual exercise that shows a pension plan's
current state of affairs. The liabilities, which, in turn, become pension payments,
extend out 50 years or more: until the last member of the plan and all plan
dependents have died. The actuary chooses an expected rate-of-return that will
apply over the lifetime of the plan. The actuary also makes assumptions about
the retention rate of current retirees, since benefits usually increase by
years of service; the correct actuarial life table (how long will members and
dependents live); and combines these with several other probabilities. Different
assumptions are a reason for the $2.0 trillion range of future obligations,
shown above.

In general, the rate-of-return being assumed by states and municipalities
is too high, often 8.0%. Thus, the discount rate for future payments is too
high. (The discount rate is the same as the rate-of-return assumption in municipal
plans. This is not true in corporate plans.) Projections of future payments
by plans using such assumptions are unrealistic.

Whatever the trillions turn out to be, the number is not of much use to interested
parties. It is more helpful to know how municipal contributions will increase
over time. These exponentialities are as varied as the pension plans - and
the municipal bonds - to which they are attached.

Be that as it may, following are figures from three different state pension
plans that may help the layman form an impression of how a specific plan might
cause municipal finance restructurings again and again in the years ahead.
There are two ways to read an actuarial valuation: either at a glance or through
hours of analysis. The former is chosen here, since that is enough to illustrate
the exponentialities; but is inadequate to address them. (Anticipating the
question, should someone want the latter, I will do so - at a price.)

Some notes:

Pension obligations apply to General Obligation bonds, not Revenue bonds,
though the eccentricities of municipal finance are bound to confound such an
absolute statement. There is no substitute for reading the documents for each
bond.

The state or town makes a "contribution" to the pension plan. The Plan is
composed of a portfolio of assets that is expected to rise in price over time.
(Thus: the importance of the actuary's rate-of-return on investments.) Benefits
are paid from this portfolio of assets. Future employer contributions
(there may also be employee contributions) are what bondholders, taxpayers,
and retirees need to monitor for potential default by the states.

Future increases of pension contributions are not the only exponentiality.
Future health costs may be higher than pension assessments. The bond owner
should read the municipalities' actuarial valuation for "Postretirement Benefits
Other Than Pensions."

Maintenance costs; because of the exponentially greater square footage of
schools, town halls, and panic rooms built over the past 20 years; have increased
expenses of such expansively minded municipalities at double-digit rates, a
rule-of-thumb is for costs being 30% higher than the previous trend of cost
increases.

The examples below were chosen because Massachusetts is local, New York's
statements are thorough and clear, and North Dakota is celebrated as an oasis
of fiscal sanity. The population (the members) of the "The State-Boston Retirement
System," as well as the municipal workers covered by other Plans, is a subset
of what the name indicates. States and cities have several different pension
plans.

#1 - The State-Boston Retirement System:

The State-Boston Retirement System (SBRS) was required to make a minimum contribution
of $143 million in 2000. This was the employer contribution. Plan participants
may have also been required to put a percentage of their paychecks into the
Plan. The minimum required contribution increased to $257 million in 2009 and
to $336 million for fiscal year 2010. The actuarial firm, The Segal Group,
estimates the minimum contribution will be $484 million in 2020. The Segal
Group is using an expected rate-of-return of 8.00% to 8.25% during that period,
and all years after.

The actuary calculates a corridor of possible contributions, from a minimum
to a maximum. The SBRS made the minimum contribution each year, which, all
else being equal, means contributions in future years have been, and will be,
higher than if it had allotted more. As municipal finance goes, the SBRS has
been prudent. See: Illinois
is No Peter Pan for the EvalKnievel approach
to pension fund management.

The Segal Group (in the person of Kathleen A. Riley, FSA, MAAA, EA, Senior
Vice President and Actuary, who signed the valuation), and all other related
parties who have an interest in achieving a compound, 10-year return of at
least 8%, may find the minimum required contribution in 2020 will be much higher
than the present estimate. Since such estimates, as well as health cost projections,
are the base from which budgets are built, as well the foundation for rating-agency
reviews, we might hope the reigning authorities have the good sense to cut
the return assumption in half. And, if pigs could fly.

#2 - The New York State and Local Retirement System:

The New York State and Local Retirement System (NYSLRS) made a contribution
of $164 million in 2000. In 2009, that had risen to $2.4 billion. What the
future holds is a mystery: these numbers are from the March 31, 2009 Comprehensive
Annual Financial Report, not the actuarial valuation. There are signs that
the contributions will only go up. From the text: "[I]n 1999, benefit payments
were approaching $3.5 billion, while this year's payments totaled $7.3 billion." Note:
these are the actual dollars paid to the retirees, not the Plan's contribution.

There is a graph in the NYSLRS Financial Report (p.21, for holders of New
York State General Obligation Bonds) that shows a steady rise of the number
of retirees over the past 10 years. The salaries of those retiring today are
much higher than those a decade ago. Since the pension received is usually
a function of the final salary and years of service, payments will rise.

#3 - North Dakota Teachers' Fund for Retirement:

The North Dakota Teachers' Fund for Retirement (NDFR) popped out in a search
for a North Dakota state plan. The Peace Garden State (as every school child
knows) was chosen because it is often mentioned as an exemplary fiscal citizen.
This choice was intended to show the condition of a pension plan with rock-solid
management.

Contributions (in this case only, the number includes both employer and employee
contributions) rose from $54.5 million in 2001 to $78.1 million in 2010. The
Unfunded Actuarial Accrued Liability (the lower, the better) changed from a
surplus of $21 million in 2000 to a deficit of $546 million in 2009, then plunged
to a shortfall of $795 million in 2009.

This is an example of the havoc wreaked by the markets in 2008, though, as
noted, the method here is glance-and-write. A full examination would elicit
other developments, such as (among many possibilities) a generous boost
to the retiree benefit formula. Similar damage can be seen from 2009 to 2010
for the SBRS, above.

This may cause a fatal blow to such plans if we suffer another such period.
Many university endowments and foundations are similarly strapped. The funding
ratio of assets to the Actuarial Accrued Liability (the higher, the better)
fell from 109% in 2000 to 82% in 2009 to 55% in 2010. The Fund's initial descent
followed the dot.com crash, when the same ratio fell from 96% in 2001 to 85%
in 2003. (Because of timing and smoothing, pension valuations reflect past
market booms and busts with a lag.) Yet, it can be roughly stated that the
funded ratio fell by half (109% to 55%) over a period when stock market returns
were approximetly zero.

Solely from inference, experience, and intuition (not knowing the asset mix
employed, etc, etc.), it was not so much the negligible returns of the past
decade, but the bust-boom-bust-boom pattern that probably did more to leave
the Plan in such poor condition. The growing unfunded liability - that needs
to be funded - will place a larger financial burden on the employer, at a time
when not much is going right.

Back to the actuary's long-term, 8% rate-of-return: this could be fulfilled,
yet, a 50% loss in the interim could sink the Plan. In the current environment
- of unprecedented government interference, thus instability in the markets
- pensions, foundations, and endowments should pay insurance, the simplest
example being put options on indexes. Insurance costs money and reduces returns
- until the moment it may save the pension fund or institution from an incapacitating
blow. A university that can no longer afford its physics laboratories, a museum
that sells its Goyas, a hospital that slashes its clinical education budget,
is not the same institution.

There has been a trend, encouraged by some consultants, for pensions, foundations,
and endowments to borrow money (for instance: borrow 100% to 200% the value
of plan assets, at a 4.5% - 5.0% interest rate) and to invest the funds with
the intention of earning a higher return while paying off the loan. Not knowing
the future, this is a reckless strategy, even though, to a committee of trustees,
it may be presented, and may sound like, the most sensible solution given a
deteriorating situation.

The government and its appendages want stocks to trade at an inflated level.
The objective of Quantitative Easing (QE), called "money printing" by the plebiscite,
was stated by Brian Sack, head of the New York Federal Reserve Markets Group,
on October 4, 2010: QE will "keep asset prices higher than they otherwise would
be." Keeping asset prices higher than they otherwise would be ensures that,
at some unknown time, asset prices will trade at a lower price than they should
be.

Sheehan serves as an advisor to investment firms and endowments. He is the
former Director of Asset Allocation Services at John Hancock Financial Services
where he set investment policy and asset allocation for institutional pension
plans. For more than a decade, Sheehan wrote the monthly "Market Outlook" and
quarterly "Market Review" for John Hancock clients.

Sheehan earned an MBA from Columbia Business School and a BS from the U.S.
Naval Academy. He is a Chartered Financial Analyst.